Dennis Carlton ‘The Anticompetitive Effects of Vertical Most-Favored-Nation Restraints and the Error of Amex’ (2019) Columbia Business Law Review 88

Ohio v American Express involved the use of what are called “no steering” restraints, in which a retailer is not allowed to use a variety of tactics to steer a consumer away from using an American Express (“Amex”) card and towards using another payment mechanism, such as money or competing payment cards. The reason why a merchant might want to do this is because the cost that the merchant incurs when a customer uses an Amex card can be higher than when the customer uses another credit card, debit card or cash. Although not challenged in the case, the Amex contractual rules also prevent a retailer from imposing a surcharge on customers who use an Amex card to reflect the higher merchant cost.

The contractual clause at stake in this case was a type of vertical most-favoured-nation (‘MFN’) restraint, i.e. a restraint in which one supplier tells a retailer that the retailer cannot set the retail price of its product higher than that of a rival, even if the supplier’s wholesale price is higher than that of its rival. This paper, which is available here, illustrates the underlying economic logic behind the anticompetitive effects of such clauses, before applying this logic to credit cards and, finally, explaining the economic errors that the US Supreme Court incurred in its recent Ohio v American Express judgment (reviewed here).

The paper is structured as follows:

Section II engages in a discussion of the economics of vertical most-favoured-nation clauses.

Suppose that there are two manufacturers producing competing products. Each manufacturer sells to a retailer at a wholesale price, and the retailer then sets the retail price for each product. Let us imagine that manufacturer A tells the retailer that the retailer must abide by the following restriction: the retail price for product A can be no higher than that for product B, regardless of any difference in wholesale prices between the two products. Manufacturer B imposes the same restriction. Both products are popular and retailers want to sell both.

These clauses have the effect of precluding price competition at the wholesale level. If Manufacturer A lowers its wholesale price, the vertical MFN prevents the retailer from lowering the retail price of product A relative to that of B, and vice-versa. Therefore, there is no gain in sales arising from the lowered wholesale price as a result of a lower retail price of A relative to the retail price of B; on the contrary, if Manufacturer A raises his wholesale price, it creates an incentive for Manufacturer B to raise its wholesale price.

Vertical MFNs make lowering the wholesale price less desirable, while increasing the incentive to raise the wholesale price. In equilibrium, the result is that the wholesale and retail prices of both products A and B are above the level that would result if there were no vertical MFNs. In other words, instead of acting like substitutes, the products act like complements. Another anticompetitive effect of such a vertical MFN precluding the entry of similar products at a lower cost.

Section IIIapplies these insights to credit cards.

Visa, MasterCard, and American Express all compete to make merchants accept their cards and customers use their cards. The credit card firm influences the fee that a merchant must pay every time a customer uses its cards. If surcharging or steering were allowed at the point of sale, a merchant could surcharge the most expensive card or otherwise discourage its use in order to induce the customer to use a cheaper card.

A no-steering provision – i.e. a clause preventing a merchant from using certain incentives to induce retail customers to use these lower cost payment mechanisms – acts just as a vertical MFN. It restricts competition compared to what it would have been in the absence of the no surcharge or no steering rule by making entry more difficult for any new credit card firm. It also causes merchant fees – i.e. the fees paid by sellers to credit card companies – to be higher than they would have been in the absence of the vertical MFN / no-steering provision.

Section IV addresses the economic errors committed by the US Supreme Court in Ohio v American Express.

The Court in Amex made two key points. First, the Court said that the credit card market is “two-sided.” As a result, any economic analysis must take account of both sides of the market. It is true that the credit-card business is two-sided, which means that the relative prices on each side of the market matter, and one should not look only at the sum of prices on the two sides of the market. In the case of credit cards, the implication is that the price a merchant pays for accepting a credit card and the rewards that a consumer receives for using a card both matter.

Second, the Court said that, because the credit card market is two-sided, different legal rules are needed to evaluate the effect of any vertical restriction in respect of whether the plaintiff or defendant bears the burden of proof. In the typical vertical restriction case, a three step procedure applies: (1) the plaintiff establishes that there is harm to the competitive process; (2) the defendant can rebut evidence of harm by showing that there is a procompetitive justification for the competitive restrictions, and (3) the plaintiff can refute this rebuttal, if necessary, by showing that, even if there is a procompetitive justification, there is a less restrictive alternative. In Amex, though, the Court ruled that, because credit cards are a two-sided market, the plaintiff had the burden of defining an antitrust market that includes both market sides, and of demonstrating that harm occurred in that two-sided market. Because the no-steering provision was said to be justified by the provision of benefits to card users and for the need to prevent free-riding, the court effectively imposed on the plaintiff the burden of fulfilling both step one and step two – i.e. the plaintiff must demonstrate that there is prima facie harm and that there are no procompetitive justifications – in order to show that there is harm to the competitive process.

The author identifies four errors with the judgment:

The Supreme Court misunderstood two sided markets. The court claimed that, because credit cards are a two-sided market, that the plaintiff had the burden of showing that the “net price” was adversely affected by the no-steering provision. However, in a two-sided platform the price on each side of the platform matters separately. That is, it is not just the sum of prices to each side, but the relative prices on each side that should be looked at when looking at a two-sided platform. Therefore, any interference with the setting of these relative prices on each side of the market is a distortion of the competitive process. That means that the no-steering rules, by their very nature, are a distortion of the competitive process, since they alter the relative prices.

While the court is correct that there can be justifications for vertical restrictions based on some well-known free riding arguments, the argument made in Amex makes no economic sense. The free riding the court talks about is the rewards that a consumer receives if he uses the Amex card; but if the merchant steers the consumer to use another card, the consumer does not receive the Amex rewards. In other words, no free riding of Amex’s rewards arises in the court’s exposition.

The court ignores what would seem like relevant economic evidence on several of the issues it raises, e.g. it ignores evidence that the no steering rule harmed entry of Discover into the credit card market, and that there was no procompetitive justification for the no-steering rule.

The fourth error relates to market definition. The court claimed that although, merchants obtain one service from a credit card firm while customers get another, the two services must be considered as one antitrust market because the outcome is a single transaction. However, a credit card performs two different complementary functions, and those two go into making a transaction. Complements are not in the same antitrust market, even though the price of one complement can affect demand for the other. For example, steel and rubber are used to make a golf club, but it would make no sense to claim that steel and rubber are in one market.

The author suspects that placing the burden on the plaintiff in the way the Court proposes will make it more difficult for plaintiffs to prevail even if there is a clear interference in the process of competition with no offsetting justification. Given the vagueness with which the Court defined two-sided markets, a firm charged with using vertical restrictions in violation of the antitrust laws will have an incentive to claim that it is operating in a two-sided market in order to take advantage of the Amex decision, which will make it harder for plaintiffs to win.